The lawyers doing the writing at the SEC are good. The 104-page novella the Commission released last week with the Commodity Futures Trading Commission gallops readers spritely to an inconclusive denouement.
No offense intended. For anybody versed in trading markets, the report is logical and easy to follow. We agree with the description of underlying trading activity, even so far as the report’s conclusion that real buyers and sellers are about 10% of the market. There are charts that look somewhat like our models of market structure, illustrating trading share by market center (we do it by behavior).
As most of you know, the report surmises that unusual macro conditions, combined with a big volume-weighted S&P futures order, plus evaporating liquidity and fleeing market participants converged in stocks May 6. Result: bad.
What the report does not do is to offer fixes. It suggests that the presence of previously undetected cliffs along the humming equity superhighway will require the installation of guard rails. That’s again logical. But is it in the best interest of issuers – and by extension investors?
Let’s think through it. Why did both liquidity and its intermediaries vanish? I found this on page 38 of the report:
Almost all of the firms we interviewed use a combination of automated algorithms and human traders to oversee their operations. As such, data integrity was cited by the firms we interviewed as their number one concern. To protect against trading on erroneous data, firms implement automated stops that are triggered when the data received appears questionable.
Whatever, precisely, “data integrity” may mean, the paragraph connotes a lack of certainty about what the data are telling participants. Where there is uncertainty, there is reticence. So why, if uncertainty dominates, don’t markets Flash Crash every day?
The answer is that they do, in part. Over dinner last weekend, a friend related a discussion he’d had with a meteorologist. This weather man told my friend that the conditions for “the perfect storm” routinely abound in pieces. They just don’t converge very often into the awful whole.
The same is true in equity markets. We see mini flash crashes in individual securities all the time. When you report results and your stock moves 10-20%, that’s a flash crash, or its inverse. Continuous trading churn, punctuated by herky-jerky price moves on new information is a claxon clanging of pricing uncertainty.
Why does this condition exist? Because of price controls. Set aside any loaded inference you might associate with that term. What it means in a vacuum is that the consumers of the product are not setting its price. Something else is. If, for instance, you are the consumer of car-repair services at Randy’s Muffler and Bailing Wire Repair Shop on the corner of Hwy 66 and Main St in Winslow, AZ, but an insurer in Zurich determines what Randy gets paid, that’s an example of a price control.
US markets – and increasingly, global markets too – function on a “maker-taker” model. Exchanges incentivize liquidity by paying traders to make, or furnish, shares – say 24 cents per hundred shares. Exchanges charges parties to “take” it; about 25 cents per hundred shares. With decimalization, or one-penny price points, enforced by regulators, and The National Best Bid or Offer – the price at which stock trades must match up – mandatory, the vast majority of trades occur through making and taking shares at high speed (high-frequency trading) – not for investment purposes.
Thus, the intermediaries who perform eight or nine of every ten trades normally, are reacting to incentives more than buyers and sellers. That’s a price-controlled market.
What happens when you remove the buyers and sellers? A Flash Crash.
How do you solve that problem? Remove the price controls. Then no one is in it for a manufactured reason, and everybody knows the real price of things. The resets when you move from price controls to their absence can be hairy. But afterward, the environment is more certain and sustainable. Unfortunately, those framing responses are planning to impose more, not fewer, price controls.
So prepare for what that will produce. Meanwhile, in stock markets right now is a giddiness over central-bank interference with prices (speaking of controls) and so program traders are pushing prices higher and investors are coming along for the ride.
We do not see any immediate abatement in this condition. But realize that it’s not real either. It’s intermediation, the same thing that promotes flash crashes in equity markets.